Digital assets have become a mainstream part of our financial system over the last several years. In particular, cryptocurrencies, the most popular type of digital asset in the market today, has seen enormous growth. In 2021, cryptocurrency market capitalization peaked at just over $3 trillion, an increase of more than 21,000% from the market capitalization of $14 billion just five years earlier. Though cryptocurrencies have seen a sharp decline in value over the course of 2022, their prevalence has not decreased. An estimated 40 million Americans continue to invest in, trade or otherwise transact using cryptocurrencies.
Despite the rise in their use, the taxation of digital assets remains rife with uncertainty. Practitioners are eager for updated guidance, as the digital asset ecosystem has significantly changed in the years since IRS guidance was last issued. A lack of reporting transactions has led the IRS to increase examination and enforcement efforts, creating additional pressure for taxpayers and practitioners. Several proposed pieces of digital asset legislation could bring direction and clarity, but they seem to be stalled in both the Senate and House of Representatives. Finally, the general oversight of digital assets is still yet to be determined; the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CTFC) are currently publicly negotiating cryptocurrency regulatory authority.
As businesses and individuals interact with digital assets with increasing frequency, it is critical for taxpayers and their advisors to understand the implications of owning and transacting with digital currencies.
Generally, digital assets use peer-to-peer networks, called blockchains, to securely record transactions. Blockchains are public databases or ledgers that memorialize transactions; new entries can be made but existing entries cannot be altered. Each entry into the database is called a block and each new block contains information about the preceding block, effectively forming a chain. (Hence, the name blockchain).
The most common ways taxpayers use digital assets are:
The decentralized nature of the digital asset ecosystem allows increased innovation and decision-making speed; as a result, the market is constantly and rapidly evolving.
Several years ago, the IRS issued guidance on the taxation of convertible virtual currencies stating they are to be treated as property, subject to general tax principles applicable to property transactions. Taxpayers recognize gain or loss on the sale or exchange of virtual currency. The type of gain will depend on whether the virtual currency is a capital asset in the hands of the taxpayer. The receipt of virtual currency as payment for goods or services can create taxable income, the fair market value of which must be measured in U.S. dollars, for the recipient.
With only limited guidance available, taxpayers and practitioners have received no direction for how to conduct many now-commonplace transactions. Furthermore, the IRS has not provided guidance for any other types of digital asset transactions outside of convertible virtual currency.
The decentralized and anonymous nature of the digital asset ecosystem, along with a lack of reporting requirements, has contributed to tax evasion in recent years. In 2021 testimony with the Senate Finance Committee, IRS Commissioner Chuck Rettig surmised annual tax evasion has likely reached $1 trillion, citing cryptocurrency as a driving force in the ever-expanding tax gap. Furthermore, a recent Barclays analysis found cryptocurrency investors are possibly paying less than half of the taxes they owe on virtual currency trades. In response, the IRS is rapidly increasing enforcement efforts related to digital asset transactions.
In 2021, the IRS unveiled “Operation Hidden Treasure,” a joint effort between the Office of Fraud Enforcement and the Criminal Investigation Unit, focusing on taxpayers who omit cryptocurrency income from tax filings. The IRS is working with third-party vendors to analyze the blockchain and identify parties who may have committed tax fraud. Operation Hidden Treasure will pursue both civil and criminal cases. In civil cases, the IRS may assert a civil fraud penalty equal to 75% of the understatement of tax.
The IRS has also been using “John Doe summonses” to gather information on taxpayers who use cryptocurrency. This type of summons is used when the IRS is seeking to obtain tax-related information when the taxpayer’s identity is unknown. In recent years, federal district courts have granted the IRS authority to investigate several virtual currency exchanges, including Coinbase, Circle Internet Financial, Kraken and SFOX. Information obtained is used by the IRS to assess taxes and penalties on unreported or underreported taxable income.
The IRS has also expanded its ability to process the data from John Doe summonses and enhance its tracking ability via well-publicized public-private partnerships with companies such as Chainalysis and TaxBit. Access to these sophisticated digital asset applications allows the IRS to pursue civil enforcement in addition to criminal enforcement. Taxpayers who non-willfully omitted digital asset transactions from a tax filing can correct mistakes by filing amended or past due returns.
Since 2019, the IRS has emphasized that owners of digital assets must report income, gains and losses on their returns by asking taxpayers about virtual currency holdings. In 2020, this question became mandatory for all individual filers. Now in 2022, the IRS plans to increase the scope of the question beyond virtual currency, to include all digital assets. The 2022 Draft Form 1040 asks:
“At any time during 2022, did you (a) receive (as a reward, award, or compensation), or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?”
It’s important that taxpayers answer this question truthfully, as a “no” response will not keep the IRS from pursuing a taxpayer who does transact with digital assets.
The Infrastructure Investment and Jobs Act (IIJA), which was signed into law in late 2021, brings about a new reporting requirement for digital assets, including cryptocurrencies. The legislation broadened the definition of securities reportable on Form 1099-B to include digital assets and expanded the definition of a broker to include those who operate trading platforms for digital assets, thereby requiring such transactions be disclosed to the IRS. In addition, the IIJA specifies digital assets will be treated as cash for certain reporting purposes; the effect is that any person or business who receives payment of more than $10,000 in digital assets will need to file Form 8300 reporting the identity of the sender. Both reporting requirements are effective for 2023 returns and statements.
Early in 2022, President Joe Biden released the “Executive Order on Ensuring Responsible Development of Digital Assets.” While the executive order does not discuss tax policy, it does highlight the importance of “addressing the risks and harnessing the potential of digital assets” and lays out a national policy across six priorities. As a result of the executive order, we expect to see additional movement in the regulation, development and use of digital assets.
The Senate and House have several pieces of proposed legislation that would affect the taxation of digital assets. While we do not expect much movement on digital asset legislation until the new Congress is seated, there is a growing urgency to regulate the ever-evolving market. Most current proposals have bipartisan sponsors, but none are viewed as likely to pass in their current forms.
The most comprehensive proposal on the table is the Lummis-Gillibrand Responsible Financial Innovation Act (RFIA). If passed, the RFIA would make significant changes to the regulation and taxation of digital assets and provide clear guidance on a number of crucial outstanding questions. Several provisions in the legislation are particularly taxpayer favorable including a gain recognition exemption for gains on personal transactions under $200, deferred tax liabilities for mining and staking rewards and nonrecognition treatment for certain loan transactions.
When the IIJA changed the reporting requirements, as discussed above, a broad definition of the term “broker” was used. There is a legitimate concern that the new law could have unintended consequences, subjecting nonfinancial intermediaries, such as crypto miners who may not have the ability to comply, to rigid reporting requirements. As a result, numerous bipartisan proposals, including the RFIA, would correct the error if enacted.
Biden is also advocating for changes to the taxability of digital assets. The General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals, commonly referred to as the “Green Book,” which highlights the administration’s revenue priorities, proposes cryptocurrency reform. Green Book proposals include new reporting requirements for purposes of international information exchange and several taxpayer-favorable changes, such as allowing dealers and traders in digital assets to use mark-to-market rules.
While we wait for Congress to act on new digital asset legislation, tax advisors are requesting additional direction from the IRS. To date, the IRS has only released two pieces of guidance: Notice 2014-21 (in 2014) and a set of frequently asked questions (in 2019). At the time of their release, the guidelines left numerous important questions unanswered. Additionally, in the intervening years, the digital asset market has drastically evolved and expanded, creating many new applications and types of transactions not covered by existing guidance.
Tax advisors are using the available IRS guidance, general tax principles and other tax law precedent to develop positions and report digital asset transactions. Any taxpayer who receives, buys, sells or gifts digital assets should consult with their Baker Tilly advisor on the tax implications prior to filing.
For more information on this topic, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.